What You Need to Know about the Economic Loss Rule (Part 2 of 2)

June 16, 2014

By Christopher J. Charles, Esq. &

David Degnan, Esq.

Prudent real estate professionals should have a general understanding of which real estate related claims are and are not recoverable – not only for themselves, but for their clients’ sake. And just as important, real estate professionals should understand how contracts may impact those claims. As discussed in last month’s article, the Economic Loss Rule [ELR] restricts certain real estate claims between contracting parties.

This article examines whether the ELR applies to negligent misrepresentation claims concerning real estate.
In order to determine whether the ELR applies, the Court must consider the underlying policies of tort and contract law. Flagstaff Affordable Housing Ltd. V. Design Alliance, Inc., 223 Ariz. at 325, 223 P.3d at 669. When viewed in the context of negligent misrepresentation or non-disclosure claims, these policies often weigh against the application of the ELR (if the ELR does not apply, then the claims may proceed).

In discussing the difference between the policy considerations underlying the doctrine of strict liability in tort, which is “designed to protect the public from dangerous products,” and the policy considerations underlying contract law, which is designed to “redress loss of the benefit of the bargain,” the Arizona Supreme Court explained:

A basic policy of contract law . . . is to preserve freedom of contract and thus promote the free flow of commerce. This policy is best served when the commercial law permits parties to limit the redress of a purchaser who fails to receive the quality product he expected. When a defect renders a product substandard or unable to perform the functions for which it was manufactured, the purchaser’s remedy for disappointed commercial expectations is through contract law.

These policy considerations certainly support the application of the ELR to a tort claim for negligence in which the plaintiff and the defendant enter into contract for the manufacture of a product and, through the negligence of the defendant, the product as manufactured does not conform to the requirements of the contract. In such a case, the parties usually will have had the opportunity to allocate the risk of loss for a nonconforming product in their contract and, even if they fail to do so, the UCC may provide remedies for the breach. Under those circumstances, it is reasonable to limit the parties to their contractual and UCC remedies. Doing so protects the parties’ commercial expectations. See Cook v. Orkin Exterminating Co., Inc., 227 Ariz. at 334, 258 P.3d at 153 (holding the ELR barred the plaintiff’s fraud and negligent misrepresentation claims for the defendant’s alleged failure to adequately perform its promises under the defendant’s agreement with the plaintiffs to treat a termite infestation.)

Indeed, the contract law policy of preserving the commercial expectations of the parties is frustrated, rather than served, when during the formation of the contract one party misleads the other party and the other party believes it will receive something that is materially different than what was promised.

Limiting the parties to their contractual and UCC remedies under these circumstances would eviscerate the expectations of the misled party and potentially leave that party without remedy. The misled party would have to foresee, and then contract around, the misrepresentation and omissions that induced it to enter into the contract in the first place. See Ares Funding, LLC v. MA Maricopa, LLC, 602 F. Supp. 2d 1144, 1149 (D. Ariz. 2009) (applying Arizona law and holding a claim for fraud in the inducement is not barred by the ELR because “fraud in the inducement does not arise from the parties’ agreement.”)

In addition to the underlying policies of contract law, the underlying policies of tort law also weigh against the application of the economic loss rule in misrepresentation cases. “Generally a cause of action for negligence arises from a duty, a determination that a person is required to conform to a particular standard of conduct.” Lips v. Scottsdale Healthcare Corp., 224 Ariz. 266, 268, 229 P.3d 1008, 1010 (Ariz. 2010). Although the law does not impose a general duty to exercise reasonable care for the purely economic well-being of others, “the tort of negligent misrepresentation recognizes a duty to exercise reasonable care in providing information to a limited class of recipients,” even though the end result of a breach of this duty is often purely economic loss. Id. at 12.

Thus, when a business supplies false information for the guidance of others in their business transaction, and a member of the limited class of persons for whose benefit and guidance the business intended to supply the information suffers pecuniary loss as a result of its justifiable reliance on the information, tort law favors imposing liability on that business for its negligent misrepresentation. This is the case despite the fact that the sole damages are a pecuniary loss. See Restatement (Second) of Torts §552 (1997).

If the ELR applies to bar any such claims for negligent misrepresentation in the inducement of a contract merely because the only loss suffered were economic damages, this tort would be largely eviscerated. The result would be inconsistent with Arizona law, which recognizes negligent misrepresentation as a valid cause of action. See Evans v. Singer, 518 F. Supp. 2d 1134, 1138-1147 (D. Ariz. 2007) (holding the economic loss rule did not bar a claim for negligent misrepresentation in the inducement of a contract for the purchase of a storage facility where the alleged misrepresentations concerned the revenues, occupancy, and profitability of the storage facility). Accordingly, the ELR should not bar claims for negligent misrepresentation claims.

Similarly, the ELR does not bar non-disclosure cases, even where the party represents that the contract is taken “as-is.” In S Development Co. v. Pima Capital Management Co., 31 P.3d 123, 201 Ariz. 10 (App. 2001), the Court held that a vendor may be liable in tort for failing to disclose latent defects, “notwithstanding the burden-shifting ‘as is’ clause or disclaimer of warranties.” Although the ELR wasn’t specifically addressed, the Court and the parties were likely guided by the above analysis.

The ELR’s scope and relevance isn’t as broad as some may suggest. The current trend is to limit its application to construction defect and product liability cases only. But when the Court concludes that the ELR does apply, the parties will be limited to only the remedies set forth in the contract. So REALTORS®, investors, contractors, buyers and sellers should be careful to ensure that their contracts adequately protect their interests in the event of a breach.

If you or someone you know needs advice regarding a real estate contract or has questions regarding a potential claim involving real estate, call or email Mr. Charles today to schedule an appointment.

Christopher Charles is a State Bar of Arizona certified real estate specialist and a former “Broker Hotline Attorney” for the Arizona Association of REALTORS® (“AAR”). Charles is a Partner with the law firm Titus Brueckner & Levine, PLC. He is an Arbitrator and Mediator for AAR regarding real estate disputes; he serves on the State Bar of Arizona’s Civil Jury Instructions Committee where he helped draft the Agency Instructions, Nuisance Instructions, and the Residential Landlord/Tenant Eviction Jury Instructions.

Charles is a licensed real estate instructor and he teaches continuing education classes at the Arizona School of Real Estate and Business. He can be reached at 480-483-9600 or via email at ccharles@tbl-law.com.

David Degnan is a real estate and construction lawyer at Titus Breuckner & Levine, PLC and may be reached at ddegnan@tbl-law.com.